Ontario government ‘solved’ a power problem that didn’t exist and got itself high prices and power shortages as a result.

On May 1, 2002, Ontario’s retail and wholesale electricity markets were opened to competition. Electricity charges were unbundled into separate components (i.e., transmission charge, energy charge, distribution charge, etc.). Consumers in the wholesale market were permitted to directly enter into bilateral physical or financial contracts with wholesale sellers and generators. Consumers in the retail market were free to enter into fixed-price contracts with retail intermediaries. Almost one million consumers entered into fixed-price contracts with retail intermediaries.

In April, 2002, the month before market opening, the Independent Market Operator, a government regulator, stated that “Ontario is expected to have reliable supply of electricity for the 10-year period [2003-2012] under a wide variety of conditions.” Initial prices following market opening were low. The weighted average hourly wholesale price was 3.01¢ per kilowatt-hour in May.

However, prices dramatically increased as the summer progressed and provincial generation capacity was unable to satisfy demand. The IMO made emergency purchases of imported energy 38 times during the summer to maintain system reliability. By September, 2002, the weighted average hourly wholesale price was 8.31¢/KwH. In October, 2002, the IMO stated that “[t]here is a serious shortage of generation capacity to meet Ontario’s growing demand for electricity. If steps are not taken to address this situation, Ontario could face even more serious reliability problems next summer, leading to the possibility of supply interruptions and continued upward pressure on prices during periods of peak demand.”

In response to mounting criticism of the high summer electricity prices, the government lowered and froze the retail price of electricity for low-volume consumers and other designated consumers (i.e., municipalities, universities and colleges, public and private schools, hospitals and registered charities) at 4.3¢/KwH until at least 2006. These consumers also received retroactive rebates for electricity prices paid in excess of 4.3¢ since market opening. In March, 2002, the retail price freeze was extended to consumers using less than 250,000 KwH/year.

The cost of the first 12 months covered by the price freeze is estimated at $1.5-billion. Approximately $950-million of the cost was covered by a pre-existing fund: the Ontario Power Generation (OPG) rebate fund (because of its market dominance, OPG is required to rebate consumers on 90% of its domestic sales where the wholesale price exceeds 3.8¢/KwH). The remaining $550-million was added to the debt of the Ontario Electricity Financial Corporation (OEFC), a government agency. Electricity ratepayers, and possibly taxpayers, will be responsible for repaying this debt.

The Ministry of Energy has stated that the price freeze will be “revenue neutral” and that the program will “pay for itself.” Virtually nobody in the industry believes the Ministry’s claims. With current gas prices, an efficient gas-fired plant cannot produce electricity for less than 6¢ to 6.5¢/KwH. The cumulative average price from market opening to the end of April 2003 was approximately 6¢/KwH.

Analysis by the IMO’s Market Surveillance Panel (MSP) found that the supply-demand imbalance during the abnormally hot summer was caused by “increased demand, a nuclear outage, deratings on fossil-fired generators due to environmental limits and less hydroelectric energy available.” The MSP concluded that there was no evidence of market power abuse. Other factors contributing to the supply crunch were constraints on import capability, the Pickering nuclear plant’s restart delay and a reduction in nuclear capacity prior to market opening. Data from the MSP also indicate that between May, 2002, and January, 2003, Ontario wholesale prices did not differ significantly from neighbouring jurisdictions (e.g., New York) except during September, 2002, when Ontario prices were significantly higher.

Therefore, despite claims to the contrary by some commentators and political parties, the price shock had little or nothing to do with deregulation or privatization. Transmission and distribution rates are regulated by the Ontario Energy Board. OPG’s wholesale electricity prices are subject to a price cap. Both Hydro One and OPG remain government owned and private-sector activity is minimal. All local distribution companies are either owned by Hydro One or independently owned by municipalities. The province has cancelled the privatization of Hydro One. OPG has sold only one generation station while leasing another. The province blocked the privatization of two coal-fuelled plants. The Pickering restart continues to experience delays and cost over-runs; the first Pickering reactor is not expected to return to service until July. Moreover, the provincial government is currently directing OPG to expand its generation capacity.

The frozen retail rate is distorting consumption decisions. Incentives to ration consumption in times of tight supply have been eliminated. This distortion will affect the wholesale market.

The province is currently facing a number of substantial problems regarding electricity supply. Over the next 15 years, 40% of Ontario’s existing capacity will be retired from service or require substantial refurbishment. All political parties have made promises to retire the province’s coal-fuelled generators. However, policy uncertainty has chilled private sector investment in new generation capacity. In March, 2003, the IMO noted that only about 2,200 megawatts (MW) of approximately 8,800 MW of planned generation was under construction. The expansion of the province’s import capacity is also in doubt. Planned expansions of the province’s inter-tie capacity have been cancelled or delayed. Alternatively, proposals requiring the province’s 93 local distribution companies (LDCs) to enter into long-term fixed price contracts with generators to cover their demand would entail similar risks for the LDCs.

The focus of policy must be redirected at the root problems if the province is to move forward. This requires renewed efforts to increase and diversify sources of supply by providing incentives for new generation and transmission capacity investment. The province must resist the temptation to directly construct new base-load generation capacity. Some industry participants recommend that the OEFC enter into long-term forward power purchase contracts with generators. These policies entail significant financial risks, chiefly the risk of entering into excessively long-term contracts at above market prices as observed in California following its electricity crisis.

Ontario policy should be directed at allowing supply and demand to interact and determine prices through full and effective market deregulation and privatization. This is the only environment that will create appropriate demand-side incentives to conserve and supply-side incentives to invest. In the transition period, there are a number of policies the province should consider pursuing. Such policies include those that would protect consumers from sharp price increases by allowing retail prices to incrementally rise to efficient levels, create “life-line” rates for low income consumers, create incentives for self- and distributed generation, harmonize market rules with neighbouring jurisdictions, expand inter-tie capacity to extend the scope of the regional market, and accelerate OPG’s decontrol program.

Michael Trebilcock is a professor and Roy Hrab is a research associate at the Faculty of Law at the University of Toronto.